Heart of darkness

Accounting firms have penetrated the UK state and their many antisocial activities are going unchecked, Prem Sikka

• guardian.co.uk, Wednesday 9 January 2008 10.30 GMT

There is something very odd about the way UK governments deal with administrative failures. In earlier times, rulers called upon obedient high-priests to manage their crises. In return for high rewards and protection, the priests engaged in some ritualistic practices and absolved their masters of all wrongdoing. The mutual back-scratching continued.

Rather than creating independent and accountable institutional structures to investigate maladministration, politicians now call upon consultants, the new high priests. A large chunk of the £2.8bn public sector contracts go to accountancy firms and they are not in the habit of blaming themselves or their paymasters for failures.

The outcome of Kieran Poynter's (chairman of accountancy firm PricewaterhouseCoopers (PwC)) investigation into the saga of the data disks lost by Her Majesty's Revenue and Customs (HMRC), is eagerly awaited. Big accountancy firms second staff to most major government departments and have an "inside" track on public policymaking. At £540 an hour (pdf, see p Ev22), the modern high-priests don't come cheap. The relationship between the state and big accountancy firms is too close and has a nasty smell to it. The firms prop up confidence in companies with soothing audit reports. During the years of the Conservative administration, they became key players in the ideological project of privatisations. They collected huge fees from the privatisation of railways, buses, steel, gas, electricity, water, telecommunications and everything else. Most of the privatised companies were grossly undervalued and facilitated a huge transfer of wealth from the taxpayer to private owners. These class warriors were also the architects of the private finance initiative (PFI (pdf)) that guaranteed huge profits to companies and themselves and kept the loans off the government's books. The firms became central to government policies and acquired friends in high places.

The revolving doors between accounting firms, politicians and senior civil servants cement the close relationship. The informed wisdom in business circles is that former ministers provide that extra degree of understanding when dealing with government departments. Before his resignation from the post of the Secretary of State for Trade and Industry, Peter Mandelson granted liability (pdf) to accounting firms. Then within days of his resignation he became an adviser to Ernst & Young. Sir Malcolm Rifkind, a former Conservative minister, is considered to be a pioneer of PFI schemes. In 2003, he became an adviser to PwC. A former head of the Inland Revenue (now HMRC) heads a PwC advisory unit and a former PwC partner is head of the tax anti-avoidance at HMRC. The former head of the UK Treasury's transport team is now KMPG's director of corporate finance. No doubt everything is above board and in accordance with the terms of liberal politics, but a public scrutiny of the power, influence and money flowing through these revolving doors is long overdue.

A US Senate report (pdf) concluded (p7) that "PricewaterhouseCoopers sold generic tax products to multiple clients, despite evidence that some ... were potentially abusive or illegal ...". The firm claims to have global standards and also operates in the UK, but no politician called for an inquiry here. The firm advises the Conservative party on taxation.

In the US, KPMG admitted to "criminal wrongdoing" and paid $456m fine in the largest-ever tax fraud case. A UK tax tribunal declared a VAT avoidance scheme (pdf) marketed by KPMG to be unacceptable. The firm advises the government on taxation.

A UK tax tribunal declared a tax avoidance scheme designed by Ernst & Young to be unacceptable. A Treasury spokesperson said, "This was one of the most blatently abusive avoidance scams most of recent years", which could have cost the taxpayer over £300m a year. No prosecutions or inquiries have followed.

The US administration completed an investigation of Enron, the disgraced US energy giant, within five months of its demise and brought charges against its auditor Arthur Andersen. The UK goes at a snail's pace. In August 2005, an investigation into MG Rover, audited by Deloitte & Touche began. An inquiry into the collapse of Farepak, audited by Ernst & Young, was announced in June 2007. So far no reports.

The late Robert Maxwell, lauded as a "great character" by John Major, then Conservative prime minister, looted over £400m from his employees' pension fund. His business empire was audited by Coopers & Lybrand (now part of PricewaterhouseCoopers). In 2001, some 10 years after the appointment of inspectors, the government eventually published its report. The report contained strong criticisms of auditors, but the auditing firm was not prosecuted though the accountancy trade associations levied a paltry fine.

The Bank of Credit and Commerce International (BCCI, pdf), audited by Price Waterhouse, was the biggest banking fraud of the 20th century. In July 1991, it was closed down by the Bank of England. In 1992, a report by US Senators John Kerry and Hank Brown concluded (ch 10, p 276) that "British auditors ... had ... become BCCI's partners, not in crime, but in cover up". Yet to date, the UK has not launched an independent investigation of the BCCI audits.

The brief evidence cited above shows that there is an unhealthy relationship between the UK state and major accounting firms. Accounting firms have penetrated the state and their many anti-social activities go unchecked. Despite dodgy audits and dubious tax avoidance schemes no UK government has ever prosecuted any major accounting firm. Is it any wonder that the public confidence in political institutions is low?

How Coopers lost the plot on Maxwell, but kept its heads

Heather Connon explains an auditor's job. And it's not to detect fraud

Observer , Sunday February 7, 1999

The complaints 'reveal shortcomings in both vigilance and diligence' and 'a failure to achieve an appropriate degree of objectivity and scepticism, which might have led to an earlier recognition and exposure of the reality of what was occurring...'

'Earlier omissions may have fostered a climate in which deception was easier to perpetrate, as it became more necessary if the empire was not to be brought down by its borrowings and need for cash...The firm lost the plot.'

These are just two of the damning findings of the Joint Disciplinary Scheme of the Institute of Chartered Accountants into the conduct of Coopers & Lybrand, auditors to most of the public and private companies in the business empire controlled by Robert Maxwell.

The empire collapsed in the weeks following his death in 1991, revealing a web of stock-lending, illegal borrowing and undisclosed dealings between the various companies, designed to conceal the fact that debt in the empire had spiralled out of control.

The report accuses Coopers & Lybrand - now merged into PricewaterhouseCoopers (PWC) - of being too close to Maxwell, who was described by the Department of Trade and Industry in 1971 as unfit to run a public company. It also attacks the auditors for trusting the representations of Maxwell and his senior executives 'without adequate investigation and consideration'.

Yet not a single head has rolled. One Coopers partner died during the investigation, but the other four remain in place. Of the £3.4 million penalty suffered by the firm and the four surviving partners, only £1.2m is in fines; the rest is the costs of the inquiry.

The firm is being sued by Grant Thornton, which took over that part of the receivership from Price Waterhouse after the merger left them with a conflict of interest, but this case will not be heard until at least 2002. And eight years on, there has been no proper explanation of the failure of the Coopers audit to alert anyone to what was going on, nor a guarantee that it will not happen in the future.

The collapse of the Maxwell empire was not the only scandal to hit auditors in the Eighties. Remember Barlow Clowes, Polly Peck, Bank of Credit & Commerce International or British & Commonwealth. While all have been followed by some payment by auditors, these were invariably out-of-court settlements aimed at curbing spiralling legal costs and, perhaps more importantly, ending the bad publicity that dogs a firm associated with a corporate collapse and subsequent legal action. In no case has an auditor admitted that it was wrong or that it should have spotted, and reported on, the disaster in the making.

So if auditors can't spot when a company is about to collapse, what exactly is their job? Why do shareholders pay such huge sums for audits when the clean bill of health the accounts are given can be so misleading?

Auditors have a ready response: the expectation gap. They've been using it since the end of the last century, when a judge decided their role was to be watchdog, not bloodhound. The expectation gap means that, while the public (and pensioners, shareholders and creditors) think auditors should be able to detect fraud, auditors know they can't and are adamant that no one can force them to.

Most frauds, they point out, involve a number of people - often senior executives - colluding to cover their tracks. Unless the collusion is so obvious that it can be spotted straight away, in which case the company should spot it, it will be impossible for an auditor, there for only a brief spell each year, to detect. Indeed, a survey by accountant Ernst & Young found that three in five frauds are uncovered purely by chance, while less than 10 per cent are detected by auditors.

The auditor can't check everything. He or she has to look at only a sample of transactions, and assess how easy it would be for staff to circumvent management's internal controls. And he is only looking at 'material' transactions - usually defined as between 5 and 10 per cent of expected profit for the year. Prem Sikka of the University of Essex, a campaigner for stiffer audits, dismisses such excuses. 'Auditors in the public sector have a statutory duty to detect and report fraud. In the financial sector, since BCCI, there has been a statutory duty to report fraud to the authorities - but not to detect it. Elsewhere, there is no duty at all.'

Sikka believes case law, particularly the Caparo judgement of 1990, which made auditors responsible only to the company as a whole, not to shareholders individually, nor third parties, means they have no 'economic incentive' to improve procedures, as they can not be held responsible for failures.

The Joint Disciplinary Scheme report says that much has changed since the Maxwell collapse. But most of the changes take the form of shouting rather more loudly about what the public should expect, rather than changing the duties of the auditor. PWC managing partner Peter Hazell points out that the problem with Maxwell was not the companies' procedures, but the fact they were not complied with. PWC has, he says, introduced a number of changes in an attempt to ensure this improves in the future. These include: specialist pension fund auditors; tightening the role of the independent partner who reviews the conduct of each audit; encouraging staff to be more sceptical and to insist on independent corroboration; and being more selective about its clients - it has resigned from 50 in the past three years.

Jon Grant, technical director of the Auditing Practices Board, which is responsible for setting standards for auditors, lists other measures affecting the profession as a whole, including the creation of his board. Since its inception, the board has created a whole new set of standards, including one which, it claims, was the toughest available on fraud until the US authorities went one step further. But it has also made sure that there is no doubt who is responsible for a company's internal controls: the directors.

A raft of corporate governance reports, from Cadbury to Hampel, have re-defined the role of non-executive directors and audit committees, making them stronger and more independent. The aim is to give suspicious auditors somewhere to go to raise the alarm. And the partner in charge of a company audit must now be changed regularly.

The APB is, however, attempting to extend the fraud debate with a consultation document. This acknowledges that one way of closing the expectation gap is to put more responsibility on to the auditor. That could mean encouraging auditors to be more sceptical,requiring them to gather more evidence to support their conclusion, or to report separately on all items they could not corroborate independently.

But it warns: 'The changes set out in this section will not eradicate fraud nor lead to all frauds being detected. But . . . [they] could provide more assurance that fraud will be detected.' The consequences, it warns, are higher costs and lengthier audits. Neither companies nor their shareholders have shown much enthusiasm for that.